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Work needed to ease sovereign debt concerns globally

Despite the pandemic, the world economy has so far been able to avoid a systemic global crisis. Key architectural changes must be made to sovereign debt to keep it that way

As global debt levels continue to rise, so too do concerns that a systemic crisis will be unavoidable if certain steps are not taken to better-manage sovereign debt.

The Covid-19 pandemic is seen as a final straw for certain countries as they struggle to cope with the economic stress brought on by the pandemic, and debt levels rise insurmountably.

Four years ago, the IMF’s fiscal monitor calculated that total global nonfinancial debt amounted to $152 trillion, or 225% of world GDP, while public debt increased by 15 percentage points of GDP between 2000 and 2015.

“As the pandemic raged throughout the world, debt turned out to be a very serious pre-existing condition. All countries face the same crushing combination: higher spending to fight the disease and protect people; and lower revenue because of the recession triggered by all necessary containment measures,” said IMF first deputy managing director Geoffrey Okamoto, at the Peterson Institute for International Economics Conference last month.

See also: Sustainable finance will emerge stronger from Covid-19 rebalancing

“Compared to pre-pandemic expectations, median debt in 2021 is projected to be up by about 17% of GDP in advanced economies; 12% in emerging economies; and eight percent in low-income countries.”

Collective action

Last month, IMF staff released a paper that took a deep dive into these issues and how they can be resolved.

It found that while the sovereign debt space faces significant challenges, there are reform options and sector policies that could improve contractual frameworks. One such policy would be to encourage the increased use of state-contingent debt such as natural disaster clauses.

“In terms of official sector policies, consideration should first be given to increased use of state contingent instruments, particularly to protect debtors against downside risks. This debt can be used much more broadly,” said Ceyla Pazarbasioglu, director of the strategy, policy, and review department at the IMF.

“This is particularly relevant during the pandemic and due to the extreme uncertainty both in terms of health and economic developments. Such instruments, in theory, can help avoid protracted negotiations between creditors and debtors over recovery values, and potentially even relapse into default post-restructuring.”

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However, these instruments provide upside to creditors – such as GDP link warrants – and have rarely been used in in practice. These are heavily discounted equity-like instruments, because of their non-standard designs, as well as their illiquidity and idiosyncratic risk profiles.

Other policies include encouraging greater debt transparency and developing debtor countries’ debt management capacity.

The paper also strongly suggests promoting wider adoption of enhanced collective action clauses (CACs).

Peter Orszag, CEO of Lazard, said that the importance of the IMF and its endorsements and role as a broker is crucial in sovereign debt markets around the world. As such, work must continue in the bid to reform and strengthen the provisions that have led to the successful resolution of recent sovereign debt crises, such as the one playing out in Argentina.

“For future progress it’s important to emphasise the importance of CACs, within which we should focus on the single limb mechanism – which is yet to be tapped – to explore whether we need to reduce the threshold or not,” he said. “Secondly, some thought should be given to the so-called uniformly applicable condition that applies when that approached is deployed, that requires certain constraints on the menu of options presented under that aggregation method, and might impede the use of that mechanism.”

There are other ways of ensuring equity for creditors that might not be the same as what is currently allowed,” he added. “You might think that making the CAC stronger would increase the cost of capital, but there is at least some evidence that it might cut in the other direction – so that bonds with enhanced CACs trade at a premium, with lower yields than other bonds.”

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More is less

Panellists agreed that the very nature of the way sovereign debt is structured needs fundamental reform if debtors are to be protected; a problem given extra urgency by the economic impact of the Covid-19 pandemic.

“The architecture of sovereign debt management looks more and more like it was made for a world that doesn't exist anymore, it is premised on a lot of bright lines that may be administratively necessary but just aren't tenable,” said Anna Gelpern, professor at Georgetown Law and nonresident senior fellow at PIIE. “The line between official and commercial debt is unbelievably blurry and always has been, official and commercial creditors likewise." 

She added that domestic and external bonds and loans look increasingly similar, which means that loans should have the same contractual matter that bonds have. “This is really not a this clause or that clause conversation. This is more a bonds, loans, funds and banks are looking awfully similar now. So what do we do about that?”

Another issue is with low and middle-income countries. The infrastructure for financing low income countries assumes small amounts of inward investment over a long period of time to develop, not so much giant flows both in and out.

However, as more countries access financial markets, and there are more exogenous shocks like pandemics and climate events, some typically low-income country problems look like old middle-income country problems. “I’m not sure we necessarily have the capacity to address that,” said Gelpern.

To remedy this issue, she recommends resolving issues with equity, transparency, and diversity.

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